Using the Price-to-Earnings Ratio as a Quick Way to Value a Stock

The New Investor's Guide to Understanding the P/E Ratio

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The p/e ratio, or price-to-earnings ratio, is a valuation tool that tells you how much you are paying for each $1 in earnings per share a stock generates. Sometimes, what looks like a low p/e ratio stock can be a trap.
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Value investors and non-value investors alike have long considered the price earnings ratio, which is also known as the p/e ratio for short, a useful metric for evaluating the relative attractiveness of a company's stock price compared to the current earnings of a firm. Made popular by the late Benjamin Graham, who was dubbed the "Father of Value Investing" as well as Warren Buffett's mentor, Graham preached the virtues of this financial ratio as one of the quickest and easiest ways to determine if a stock is trading on an investment or speculative basis, often offering some modifications and additional clarification so it had added utility when viewed in light of a company's overall growth rate and underlying earning power.

On that same note, as you read this introductory article and discover how useful the P/E ratio can be, keep in mind you can't always rely on price-to-earnings ratios as the be-all-end-all yardstick in determining whether a company's stock is expensive. There are some significant limitations, partly due to accounting rules and partly due to the terribly inaccurate estimates most investors conjure out of thin air when guessing future growth rates. Regardless of those shortcomings, it is something you should know how to define and how to calculate by heart.

The P/E Ratio - What It Is and Why Investors Care

Before you can take advantage of the p/e ratio in your own investing activities, you need to understand what it is. Simply put, the p/e ratio is the price an investor is paying for $1 of a company's earnings or profit. In other words, if a company is reporting basic or diluted earnings per share of $2 and the stock is selling for $20 per share, the p/e ratio is 10 ($20 per share divided by $2 earnings per share = 10 p/e).

Note that for the sake of conservatism, you should probably always prefer the diluted earnings per share when calculating the P/E ratio so you account for the potential or expected dilution that can or will occur due to things like stock options or convertible preferred stock.

The great news if you are inexperienced with investing is that most financial portals and stock market research sites will automatically figure the price-to-earnings ratio for you. Once you have the magic number, it's time you begin wielding its power. It can help you differentiate between a less-than-perfect stock that is selling at a high price because it is the latest fad among stock analysts, and a great company which may have fallen out of favor and is selling for a fraction of what it is truly worth.

First, you have to understand that different industries have different p/e ratio ranges that are considered "normal".

For example, technology companies may sell at an average p/e ratio of 20, while textile manufacturers may only trade at an average p/e ratio of 8. There are exceptions, all things considered, these variances between sectors and industries are perfectly acceptable. They arise, in part, out of different expectations for different businesses. Software companies usually sell at larger p/e ratios because they have much higher growth rates and earn higher returns on equity, while a textile mill, subject to dismal profit margins and low growth prospects, might trade at a much smaller multiple. From time to time, the situation is turned on its head. In the aftermath of the Great Recession of 2008-2009, technology stocks traded at lower price-to-earnings ratios than many other types of businesses, such as consumer staples, because investors were frightened.

They wanted to own companies that manufactured products that people would continue purchasing no matter how strained their finances; companies like Procter & Gamble, which makes everything from laundry soap to shampoo, Colgate-Palmolive, which makes toothpaste and dish soap, Coca-Cola, PepsiCo, and The Hershey Company. There is a saying in the international investing market for wealthy families that sums this sentiment and tendency up succinctly: "When the going gets tough, the tough buy Nestle." (Referring to Nestle, the Swiss food giant that is one of the largest companies in the world and has a stable of products that generate billions upon billions of dollars in nearly every country, no matter how terrible things get. From coffee, pasta, and baby food to ice cream, pet supplies, and beauty products, it is almost impossible for a typical member of Western Civilization to go a year without somehow, someway, directly or indirectly putting cash in Nestle's coffers, which explains one of the reasons it is one of the most successful long-term investments in existence.)

One potential way to know when a sector or industry is overpriced is when the average p/e ratio of all of the companies in that sector or industry climb far above the historical average. Historically, this has spelled trouble. We saw the repercussions of just such gross-over pricing in the technology crash following the dot-com frenzy of the late 1990's and, later, in the stocks of companies linked to real estate. Investors who understood the reality of absolute valuation knew it had become a near mathematical impossibility for equities to generate satisfactory returns going forward until the excess valuation had either burned off or stock prices had collapsed to bring them back in line with fundamentals. Men like Vanguard founder John Bogle went so far as to sell off all but a fraction of their stocks, moving the capital to fixed income investments such as bonds. Such situations tend only arise every few decades but when they do, tread carefully and make sure you know what you are doing. Benjamin Graham was fond of averaging profit per share for the past seven years to balance out highs and lows in the economy because, if you attempted to measure the p/e ratio without it, you'd get a situation where profits collapse a lot faster than stock prices making the price-to-earnings ratio look obscenely high when, in fact, it was low. A perfect illustration comes in 2009 when the stock market fell apart. Frankly, I'm not sure the inexperienced investor should pay attention to it, instead opting for a systematic, or formulaic, approach.

Using the P/E Ratio for Comparison of Companies in the Same Industry

In addition to helping you determine which industries and sectors are overpriced or underpriced, you can use the p/e ratio to compare the prices of companies in the same area of the economy. For example, if company ABC and XYZ are both selling for $50 a share, one might be far more expensive than the other depending upon the underlying profits and growth rates of each stock.

Company ABC may have reported earnings of $10 per share, while company XYZ has reported earnings of $20 per share. Each is selling on the stock market for $50. What does this mean? Company ABC has a price-to-earnings ratio of 5, while Company XYZ has a p/e ratio of 2.5. This means company XYZ is much cheaper on a relative basis. For every share purchased, the investor is getting $20 of earnings as opposed to $10 in earnings from ABC. All else being equal, an intelligent investor should opt to purchase shares of XYZ. For the exact same price, $50, he is getting twice the earning power.

The Limitations of the P/E Ratio

Remember, just because a stock is cheap doesn't mean you should buy it. Many investors prefer the PEG Ratio, instead, because it factors in the growth rate. Even better is the dividend adjusted PEG ratio because it takes the basic price-to-earnings ratio and adjusts it for both the growth rate and the dividend yield of the stock.

If you are tempted to buy a stock because the p/e ratio appears attractive, do your research and discover the reasons. Is management honest? Is the business losing key customers? Is it simply a case of neglect, as happens from time to time even with fantastic businesses? Is the weakness in the stock price or underlying financial performance a result of forces across the entire sector, industry, or economy, or is it caused by firm-specific bad news? Is the company going into a permanent state of decline?

Once you get more experienced, you will actually use a modified form of the p/e ratio that changes the "e" portion (earnings) for a measure of free cash flow. I prefer something called owner earnings. Basically, I use it, adjusted for temporary accounting issues, and try to figure out what I'm paying for the core economic engine relative to my opportunity costs. Then, I construct a portfolio from the ground-up that not only contains individual components that were attractive but that, together, help me reduce risk.